By Vinod Kothari,

Microfinance Focus, July 7, 2011: Finally, the Microfinance Institutions (Development and Regulation) Bill has been put up on the website of the Ministry of Finance. Though titled as “Development and Degulation Bill, as would be expected, the stance of the Bill is more on regulation, than on development. Also, as would be expected, the Bill is full of drafting problems and language inconsistencies, though it has had the benefit of the Malegam Committee’s recommendations.

Overview of the Bill and its major drafting problems:

For starters, the Bill provides a mandatory registration. Clause 10 is the most important provision that provides that no MFI shall either commence or carry on the business of micro finance services without registration with the RBI. The key words are – microfinance institution, and micro finance services. Micro finance institution (MFI) is defined in clause 2 (f) to mean any entity which is engaged in providing micro finance services. Therefore, whether incorporated or not, if any entity provides microfinance services, it needs to come under the regulatory ambit.

The definition of “microfinance services” becomes critical. Clause 2 (g) defines microfinance services to mean any of micro credit, collection of thrift (again a defined term – see later), remittance, pension or insurance services, or other notified services. First of all, the word “micro credit” itself is not defined. As the definition connects with the regulatory ambit of the law, and therefore, goes into the very core of the enactment, it would be fatal to have a loose definition. First of all, there is no monetary limit to the definition of micro credit provided in the law – that is, loans of what amount are “micro credit”, and beyond what amount they cease to be micro credit. Neither is there a definition by reference to who the borrower is  - that is, whether loans to rural or urban or both borrowers would be micro credit. Since the word “credit” is not defined (the word “financial assistance” is defined, but that has not been integrated with the definition of “credit”), there would be questions as to whether a micro leasing service will be a micro credit? If a seller sells an asset, and provides for payment of the price on instalment, would that amount to micro credit? There is a power with the government to notify services that may be included in the definition of “micro finance services”, but unfortunately there is no power to notify what is the monetary limit of lending upto which a financing is micro credit.

As for existing MFIs, a time frame of 3 months has been allowed to make application for registration. It would not be unexpected that when the date of enforcement of the Act is notified, there would be a mad rush to the RBI for registration – the like of which was seen in 1988 when NBFCs were registered for the first time. In case of MFIs – all the more a reason for the rush, as the net worth required for MFIs is only Rs 5 lacs. Besides, MFIs exist in most remote parts of the country – currently, they may not even be on the radar as they might be unincorporated bodies. Now they will rush for registration – the RBI is surely going to have a tough time.

The Bill also brings in the concept of “thrift” services. Thrift is defined in clause 2 (p) to mean collection of time deposits. This seems to suggest that the RBI is inclined to permit MFIs to accept deposits too – a long-felt need. There is a mention in the marginal  notes below section 14 about thrift services, but it seems that that provision actually fell through the creeks somewhere along the way, as there is no substantive provision in the law about thrift acceptance.

Regrettably, the overlap between NBFCs and MFIs remains under the Bill. It would be most illogical to have a company carrying out microfinance business being regulated both as an NBFC and as an MFI. However, Clause 11 (3) and (4) clearly suggest that such overlap will continue – which is a regrettable waste of regulatory attention. In fact, the Bill mandates that an MFI that becomes systematically important (based on a number of borrowers  - the number to be notified by the RBI) will have to convert itself into a company. Once it converts, it obviously becomes an NBFC also.

The draftsmen of the Bill has obviously used the NBFC provisions of the RBI Act – as is clearly indicated by the flow of provisions and the requirements for creating a reserve, etc.

Every MFI will require an audit, and will have to file periodic returns with the RBI.

The RBI has been given the power to notify directions applicable to NBFCs – including limitations on annual percentage rate, margin, etc.

Minor Drafting problems:

Minor drafting problems abound. Take, for instance, the very first definition in the Bill – that of “annual percentage rate” – the definition fails to say that it is referring to the annual rate. It just defines the annual percentage rate as the “aggregate rate”, and  not “aggregate rate per annum”. The same is also the problem with the definition of “margin” or the reference to the cost of funds – it nowhere says that the cost is an annual cost.

Operational controls on MFIs

Besides registration, audit and reporting requirements, there are important controls on the operations of MFIs. One of the important provisions is the mandatory disclosure of the annual percentage rate being charged on loans – this would be “distinctly and prominently” disclosed in the loan document and the sanction letter. It is a different issue that most MFIs do not have anything called a sanction letter.

The compliance of this requirement, and that of the maintenance of the “margin”  - that is, difference between (a) the annual percentage rate and (b) the  cost of funds and the cost of operations, will also have  to be certified by the auditor. The certification may be really really tough – for example, at what point of time does the auditor test whether the margin was maintained? One has to understand that the cost of funds and the cost of operations are not static. Even if one may annualize the cost of funds, anyone with slightest sense of finance would know that the cost of operations cannot be annualized. Cost of operations is a fixed or semi variable function. The law does not even provide for how to express the cost of operations as a percentage – percentage of what? Even one takes the unwritten meaning and takes it to mean percentage of total assets, what all costs are taken as operational costs is unclear. Also, it is purely rudimentary understanding that at the beginning stage of business, an entity’s cost of operations is always higher, as cost of operations has an inherent economy of scale. The cost of operations is different at the start of the year, and at the end of the year. One understands cost of operations as a financial concept, but to think of putting that into a law and regulating entities based on it, and also expecting auditors to certify the compliance with that regulation, there would be too many definitional uncertainties.

The concept of control on margins, based on cost of funds and operational costs, is not, in fact, a drafting problem – it is a conceptual problem that even the Malegam Committee also had.

Does it surprise anyone that the approval of the RBI will be needed not just to get born or remain alive, but also to die? Clause 27 says that no one can even wind up MFI services without the approval of the RBI. So what if the Bill makes it difficult to sustain and one has to wind up?

Developmental agencies:

The Bill provides for a Microfinance Development Council, and Councils at State level. The Council’s role is purely advisory – to advise the government on matters concerning the development of the microfinance sector. The  Council will not have any regulatory role. The State councils are also advisory – though they get into complex questions of whether microfinance is resulting into excessive indebtedness, whether recovery practices being adopted by the MFIs are fair etc. In essence the Councils provide a political safeguard to the government which has faced scathing criticism on account of borrowers’ suicides and similar issues.

The Bill also provides for ombudman, microfinance development fund, etc.

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(Disclaimer: Views expressed in the article by the author are his own and do not necessarily represent those of Microfinance Focus. Microfinance Focus does not take any responsibility for correctness of the data presented by contributors.)